Investors Stay Calm, If Cautious, as Stalemate Simmers

Politicians remain locked in a rancorous debate over impending tax increases and spending cuts, and it remains unclear if a deal will be reached by the end of the year. But investors are already betting that lawmakers will do enough to avoid heading over the so-called fiscal cliff.

Fears that the divide separating Republicans and Democrats might be too great to bridge helped send markets down in the week after the election. More recently, share prices have climbed steadily, rising for most of the last three weeks to reach their highest point since late October.

The Standard & Poor's 500-stock index ended Wednesday flat, up 0.04 percent, to 1,428.48, after briefly spiking after the Federal Reserve's announcement that it was expanding its bond-buying programs to stimulate the economy. The afternoon drop was attributed to the Fed's projection that the economy would grow slightly less than expected next year. The benchmark index is now up almost 14 percent for the year.

"Clearly there is no nervousness in the market at all," said David Woo, the head of global interest rate research at Bank of America Merrill Lynch. "There is a lot of complacency."

The current rally has been fueled by the broad consensus among investors that Congress and the White House have narrowed their differences enough to make an agreement inevitable. But these same traders and strategists also are waiting for the first sign that negotiations in Washington are going to derail. In a survey conducted by the Potomac Group, nearly two-thirds of investors said that if an agreement was not reached by Dec. 31, the Dow Jones industrial average was likely to fall at least 10 percent.

Greg Valliere, a researcher at the Potomac Group, is among a loud minority on Wall Street that believes the current confidence is misplaced, given the recent track record of politicians on finding solutions to tough fiscal problems.

"Many people in the markets feel that its unthinkable that Washington would do something this irresponsible," said Mr. Valliere. "After following Washington for 30 years, I would argue it is not unthinkable."

The debate over taxes and spending is not the only thing that has helped stock prices higher. A growing stream of economic data has pointed to a strengthening recovery in the housing market and an improvement in the employment picture. The Fed also has continued its efforts to support the economy by keeping borrowing costs down and pushing investors into riskier assets.

Still, Wall Street has been fixated on every twist and turn in the negotiations in Washington. A Barclays survey of 400 of its clients found that a significant majority believed that "mismanagement" of fiscal policy posed the most significant near-term threat to markets.

The state of the debate in Washington seems to vary by the hour and the politician at the microphone. Speaker John A. Boehner said Wednesday morning that he and President Obama remained "far apart" on a possible deal.

Ken Taubes, the chief investment officer at Pioneer Investments, said that despite such rhetoric, he was betting on a last-minute agreement because many Republicans had already conceded that taxes needed to rise and many Democrats, including the president, had said that spending would fall.

A failure to reach a compromise "just seems like such a low probability event given that everyone knows what has to happen, and how bad the consequences are if it doesn't," Mr. Taubes said.

A number of indicators, such as the price of military contractors' stocks, suggest that Mr. Taubes's view is widely shared. The Department of Defense is to have its budget slashed next year if there is no resolution to the negotiations. But since the election, shares of military contractors are actually doing better than the broader market.

Others can recall recent episodes where the confidence that Wall Street had placed in politicians proved to be misplaced. In the summer of 2011, investors knew for months that the United States was approaching its legally mandated debt ceiling, but it was only a week before the deadline that stocks started to plunge. The sharpest drop came when Standard & Poor's lowered the country's credit rating, after a last-minute agreement was reached. Those losses were ultimately recovered.

Leon LaBrecque, the founder of the asset manager LJPR, said he has already prepared for a breakdown of the talks in Washington by scaling back his stock holdings by 25 percent. He said he would start buying after an agreement was reached.

"We're in cliff mode right now," said Mr. LaBrecque.

There are several possible outcomes. The president and Congressional leaders have expressed their desire for a sweeping agreement that creates certainty on the budget for the coming years. Most on Wall Street discount that possibility, and expect what Garth Friesen of the hedge fund III Associates calls "a patch with a promise." This would involve a short-term agreement that pushed broader negotiations into next year.

Mr. Friesen said his firm assumed the chances of that happening at 80 percent. If it looks like even a temporary solution is eluding politicians, Mr. Friesen said he had contingency plans for the markets turning sour.

A number of analysts have said that an agreement that delays difficult decisions could still affect the markets, particularly if it leads another credit rating agency to lower its rating of the United States.

If there is a quicker agreement, it could give stocks at least a temporary bounce. But Mr. Valliere and other Washington analysts are already looking to the next opportunity for gridlock, the debt ceiling the country is expected to hit early next year.

"You could argue that a debt ceiling default scenario could be even more worrisome for the markets later in the winter," said Mr. Valliere.